Download - Loanable Funds Market
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Loanable Funds Market
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• Four key markets coordinate the
circular flow of income. • The resource market coordinates the actions of businesses demanding resources and households supplying them in exchange for income.
• The loanable funds market brings net household saving and the net inflow of foreign capital into balance with the borrowing of businesses and governments.
• The foreign exchange market brings the purchases (imports) from foreigners into balance with
the sales (exports plus net inflow of capital) to them.
• The goods & services market coordinates the demand for and supply of domestic production (GDP).
The Circular Flow Diagram
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Loanable Funds Market• The interest rate coordinates the actions of
borrowers and lenders.• From the borrower's viewpoint, interest is the
cost paid for earlier availability. • From the lender’s viewpoint, interest is a
premium received for waiting, for delaying possible expenditures into the future.
• The money and real interest rate:• When inflation is anticipated, lenders will
demand (and borrowers pay) a higher money interest rate to compensate for the decline in the purchasing power of the dollar.
• This premium for the expected decline in purchasing power of the dollar is called the inflationary premium.
Realinterest rate =
Inflationarypremium
Moneyinterest rate –
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• Suppose that when people expect the general level of prices to be stable (zero inflation) in the future, a 5% interest rate brings equilibrium in the loanable funds market.
InterestRate
Quantityof funds
S (stable prices expected)
D (stable prices expected)
Q
.05
Inflation and Interest Rates
• Under these conditions, the money and real interest rates will be equal (here 5%).
Loanable Fundsmarket
Here, the moneyand real interestrates are equal
i = r =
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InterestRate
Quantityof funds
S (stable prices expected)
D (stable prices expected)
Q
.05
Inflation and Interest RatesLoanable Funds
market
D (5% inflation expected)
S (5% inflation expected)
r =
.10 i =
Inflationary premiumequals expectedrate of inflation
• When people expect prices to rise at a 5% rate, the money interest rate (i) will rise to 10% even though the real interest rate (r) remains constant at 5%.
Q
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Interest Rates and Capital FlowsLoanable Funds
market
• Demand and supply in the loanable funds market will determine the interest rate.
Supply ofloanablefunds
D0
Q1
r2
r1
D1
D2
Domesticsaving
Q2 Quantityof Funds
• When demand for loanable funds is strong (D2), real interest rates will be high (r2) and there will be a inflow of capital.
• In contrast, weak demand (D1) and low interest rates (r1) will lead to capital outflow.
InterestRate
Capitaloutflow
Capitalinflow
r0
Q0
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Net Saving + = Investment + Budget DeficitImports - Exports
Net Saving + = Investment +Imports - Exports GovernmentPurchases - Taxes
Net Saving + = Investment + GovernmentPurchasesImports + ExportsTaxes+
Leakages Injections
Leakages and Injections from the Circular Flow of Income
• Budget deficit = (government purchases - taxes):
• Which may be re-written as:
• Therefore, when the loanable funds and foreign exchange markets are in equilibrium, leakages from the circular flow of income (savings + imports + taxes) are equal to injections into it (investment + government purchases + exports).
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• Macro equilibrium will be present when the flow of expenditures on goods & services (top loop) is equal the flow of income to resources owners (bottom loop).
• Hence, when equilibrium is present
in the loanable funds and foreign exchange markets, injections equal
leakages and Macro equilibrium will be present.
• This condition will be present when the (investment, government purchases, & exports)
into the circular flow …
injections
equal the (saving, taxes, and imports) from it.
leakages
The Circular Flow Diagram